Skill Level Beginner
- A 401(k) is a common form of what is called a defined contribution retirement plan. It is called a defined contribution plan because the employer defines the amount that will be contributed to the plan. An employer may contribute a fixed amount each month to an employee's 401(k), or they may match the employee's contribution to the plan up to a certain cap. Either way, the employer contributes to the employee's 401(k) retirement plan and then the employer is off the hook.
Their only obligation is to make the agreed-upon contribution. The risks associated with how much of that money will be there upon retirement lies 100% with the employee. The amount will depend on how long until retirement, what types of investments are made with the contributions, and whether any amounts are withdrawn before retirement. These defined contribution plans are the rule nowadays for two reasons. First, employees change jobs a lot, and their 401(k) can go with them from job to job.
Employees like that feature. The second reason is that the risks of the retirement fund lie with the employee. Employers like that feature. What used to be more common and is still around in older organizations is what is called the defined benefit plan, more commonly referred to as a pension. It used to be that you worked for the same organization for your entire career, and that organization took care of you after you retired. How much you were provided upon retirement was a function of a number of factors. For example, my employer Brigham Young University, offers me a pension plan.
I have been with my university for 30 years. My pension will be based on the number of years I will have worked when I retire and the average of my highest five years of salary. In effect, I will receive about 50% of my salary after I retire until I die. And assuming I die first, my wife will continue to receive that amount until she dies. Good for us but not necessarily good for my employer. How much is my employer going to have to pay me when I retire? That's a tough number to figure out. If I live a long time and my wife lives an even longer time, my employer is on the hook for a lot of money.
With a defined benefit plan the employer bears all the risk. How much they will pay is based on a lot of factors outside their control. That is why you see defined benefit plans going by the wayside. For example, my employer has significantly reduced the defined benefit package offered to new employees and has increased the amount they are contributing to those employees' 401(k). With a defined contribution retirement plan, the employer defines the contribution and the employee bears the risk upon retirement.
With a defined benefit retirement plan, the employer defines the benefit and then the employer bears the risks associated with satisfying the obligation associated with those benefits. Because those benefits can be far into the future, it might be hard to get a handle on them and to have the appropriate funding set aside when those pension payments need to be made. We are seeing this in the headlines today. Many state and local governments have pension plans that are underfunded by billions of dollars. Some of the austerity measures taken by governments around the world relating to the recent financial crisis relate to satisfying the obligations associated with significantly underfunded pension plans.
Estimating and paying for benefits in the future is difficult. Making payments today and being done with it is much easier. That is why we see companies and governments nowadays getting out the defined benefits business and sticking with making defined contributions. This strategy puts the risk of funding retirement on the individual not on the organization.
Q: Why can't I earn a Certificate of Completion for this course?
A: We publish a new tutorial or tutorials for this course on a regular basis. We are unable to offer a Certificate of Completion because it is an ever-evolving course that is not designed to be completed. Check back often for new movies.